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FDIC, FRB, OCC, OTS: Proposed Guidance on Complex Structure Finance Transactions

ABA Contact: Compliance staff
Published: 71 Federal Register 28326; May 16, 2006
Comments Due: June 15, 2006
Disposition: Filed

On May 19, 2004, the Agencies requested comment on a proposed Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities (Interagency Statement) for financial institutions, including banks, savings associations, broker-dealers and investment companies. See entry in the ABA 2004 Reg Chart. ABA and a number of financial institutions strongly opposed the issuance of the Interagency Statement as it was proposed, and all urged that the Agencies make a number of changes to make it less prescriptive and more focused on those complex structured finance transactions (CSFTs) that increase legal and reputational risk to the institution.

On May 16, 2006, the Agencies proposed a revised Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities (Revised Statement). It appears that the Agencies have substantially revised the Interagency Statement to be more principles-based and to focus on only those elevated risk CSFTs. ABA is currently requesting input from bankers on whether the revised statement is now acceptable.

The Revised Statement begins by listing a number of CSFTs that do not pose elevated risk and goes on to state that the Revised Statement "will not affect or apply to the vast majority of financial institutions, including most small institutions."

The Revised Statement now provides that:

A financial institution that engages in CSFTs should maintain a set of formal, firm-wide policies and procedures, which may be part of broader policies and procedures, that are designed to identify, evaluate, assess, document, and control the full range of credit, market, operational, legal and reputational risks associated with these transactions.

A financial institution should define what constitutes a "new" complex structured finance product and establish a control process for the approval of such new products by considering whether it contains structural or pricing variations from existing products, whether the product is targeted at a new class of customers, whether it is designed to address a new need of customers, whether it raises significant new legal, compliance or regulatory issues, and whether it or the manner in which it would be offered would materially deviate from standard market practices.

New complex structured finance products to receive the approval of all relevant control areas that are independent of the profit center before the product is offered to customers. In particular, the review process should identify CSFTs that pose elevated risk to the institution. Signs of such elevated risk include:

  • Lack economic substance or business purpose;
  • Be designed or used primarily for questionable accounting, regulatory, or tax objectives, particularly when the transactions are executed at year end or at the end of a reporting period for the customer;
  • Raise concerns that the client will report or disclose the transaction in its public filings or financial statements in a manner that is materially misleading or inconsistent with the substance of the transaction or applicable regulatory or accounting requirements;
  • Involve circular transfers of risk (either between the financial institution and the customer or between the customer and other related parties) that lack economic substance or business purpose;
  • Involve oral or undocumented agreements that, when taken into account, would have a material impact on the regulatory, tax, or accounting treatment of the related transaction, or the client s disclosure obligations;
  • Have material economic terms that are inconsistent with market norms (e.g., deep in the money options or historic rate rollovers); or
  • Provide the financial institution with compensation that appears substantially disproportionate to the services provided or investment made by the financial institution or to the credit, market or operational risk assumed by the institution.

When an institution identifies a CSFT that has elevated risk, it should practice heightened due diligence. For example, a financial institution that structures or markets an elevated risk CSFT to a customer, or that acts as an advisor to a customer or investors concerning an elevated risk CSFT, may have additional responsibilities under the federal securities laws, the Internal Revenue Code, state fiduciary laws or other laws or regulations and, thus, may have greater legal and reputational risk exposure with respect to an elevated risk CSFT than a financial institution that acts only as a counterparty for the transaction. the institution may find it useful or necessary to obtain additional information from the customer or to obtain specialized advice from qualified in-house or outside accounting, tax, legal, or other professionals.

A financial institution's policies and procedures should provide that CSFTs identified as having elevated legal or reputational risk are reviewed and approved by appropriate levels of control and management personnel.

If, after evaluating an elevated risk CSFT, the financial institution determines that its participation in the CSFT would create significant legal or reputational risks for the institution, the institution should take appropriate steps to address those risks, such as by declining to participate in the transaction, or conditioning its participation upon the receipt of representations or assurances from the customer that reasonably address the heightened legal or reputational risks presented by the transaction. A financial institution should decline to participate in an elevated risk CSFT if, after conducting appropriate due diligence and taking appropriate steps to address the risks from the transaction, the institution determines that the transaction presents unacceptable risk to the institution or would result in a violation of applicable laws, regulations or accounting principles.

A financial institution should create and collect sufficient documentation to allow the institution to:

  • Document the material terms of the transaction;
  • Enforce the material obligations of the counterparties;
  • Confirm that customers have received any required disclosures concerning the transaction; and
  • Verify that the institution's policies and procedures are being followed and allow the internal audit function to monitor compliance

Institutions engaged in more than plain vanilla CSFTs should also set a high ethical standard from the top of the institution on down, should monitor for compliance with policies and procedures, should identify and specially train relevant personnel in these issues, and provide for audit and reporting on the handling of CSFTs.

2006 Regulatory Chart
Federal Register
Final Rule
Comment Letter